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Understanding Securities Analyst Recommendations

Introduction

Investors considering stocks have a din of data to sift through today.

Unfortunately, quantity is no guarantee of quality: It has never been harder for small investors to assess which information they should rely upon to make decisions. As a result, some investors have depended too heavily on the one-word recommendations of just a few analysts—without understanding the particular context in which such recommendations often are generated, and the particular ways in which they often must be read.

Analysts play a useful role in our capital markets. For example, by doing in-depth research for their large institutional clients and employers, analysts can help substantial sums of capital be directed to more productive uses in our economy.

This article explains what analysts do and places it in perspective, so investors can learn what other information they need for managing their portfolios.

The two key takeaways are: 1) analysts' ratings do not have clear, standardized meanings; and 2) analysts might have potential conflicts of interest that you, as an investor, should be aware of in assessing the usefulness to you of any particular analyst recommendation.

Same Word, Different Meanings

Analysts usually summarize their research reports with a brief recommendation. Every firm uses its own rating system. Here are examples from three firms:

Firm A

Firm B

Firm C

Buy

Strong Buy

Recommended List

Outperform

Buy

Trading Buy

Neutral

Hold

Market Outperformer

Underperform

Sell

Market Perform

Avoid

Market Underperformer

As you can see, comparing these ratings scales is not easy. The same term might mean one thing for one firm and something else for another firm:

For example, as you can see above, Firm A rates its most positive recommendations as "Buy," but Firm B does not. When Firm B uses a "Buy," it means that Firm B likes the stock, but not as much as the stocks that it rates "Strong Buy."

Likewise, one firm's "Underperform" might mean that it expects a stock to appreciate 10 percent slower than the overall market over an 18-month period. For another firm, the same term "Underperform" might mean that it expects the stock to drop 5 percent within a 12-month period.

Clear "Sell" ratings have grown rare. Some firms no longer even use "Sell" or any word obviously like it. Frequently, a "Hold" rating in effect means "Sell."

Even providers of so-called "consensus" ratings, such as I/B/E/S and First Call, use their own rating scales. These organizations apply numerical formulas to map several analysts' different ratings scales to their own rating conventions. They then average their standardized recommendations to create a "consensus" rating for a particular security.

For all these reasons, it can be potentially damaging to your portfolio to automatically accept an analyst recommendation. Before you act on a recommendation, keep the following in mind:

Is it right for YOU? A "Buy" rating does not mean that every investor should acquire the stock. Nor does a "Sell" rating mean that every investor should immediately sell it. Your own financial situation and investment needs are what matter. If you consider any individual rating, do not view it in absolute or abstract terms, but in the context of your own unique financial situation.

Never rely on a rating alone. Do your investment homework. When considering an analyst recommendation, look at the full research report, not just the one-word rating. The full report will often provide information that is essential to explain risk factors or to put the recommendation into its proper perspective.

Analysts differ in quality. As in any other field, not every analyst can be the best. To learn about different analysts' track records, you can either follow their recommendations over time, or refer to rankings that are found in certain investor-oriented magazines, newsletters and Internet websites. Some websites provide consensus recommendations, essentially an average of a number of analysts' recommendations.

Conflicts of Interest

Research analysts study companies and draw on a wealth of industry, economic, and business trend information to help their clients make better investment decisions. Retail investors may believe that most analysts' primary obligation is to the investing public. In fact, the full story is much more complicated.

Some analysts are unaffiliated: they sell their independent research to financial or investing institutions, banks, insurance companies or private investors on a project or subscription basis. But a large number of analysts are employed by institutions whose financial stake in their recommendations may go well beyond their accuracy.

For example, many analysts work for large financial firms that underwrite securities. An underwriter acts as an intermediary between the company publicly offering securities and investors buying the new stock. Even after the initial public offering, or IPO, it may have an ongoing relationship with the company or own a significant amount of the company's stock. And it will often stand to benefit from analyst recommendations that would tend to support the price of, or encourage trading in, that security.

Other analysts work for institutional money managers, such as mutual funds, hedge funds or investment advisers. They may provide research and advice for institutional clients whose investment decisions can differ significantly from those faced by ordinary investors. A mutual fund that relied on its analyst's earlier positive recommendation in acquiring the stock of a company might be harmed by any revised recommendation that would tend to lower the market value of the security.

Just by thinking about these kinds of employment arrangements, you can begin to imagine the kinds of conflicts that analysts may face as they develop and offer their opinions in research reports. For example:

Investment Banking Relationships. Providing investment banking services, such as underwriting an IPO or advising on a merger or acquisition, can be a lucrative source of revenue for an analyst's firm. Thus, the analyst may feel an incentive not to say or write things that could jeopardize existing or potential client relationships for their investment banking colleagues. On the other hand, the analyst may also be more knowledgeable or diligent in his research because his firm did the underwriting.

Analyst Compensation. Brokerage firms' compensation arrangements can put pressure on analysts to issue positive research reports and recommendations. For example, many analysts are paid at least partly and indirectly on the basis of their firms' underwriting profits. So they may be reluctant to make recommendations that could reduce such profits, and hence their own compensation.

Brokerage Commissions. An analyst's report can help firms make money indirectly by generating more buying and selling of covered securities—which, in turn, result in additional commissions for the firm.

Buy-Side Pressures. A mutual fund with large holdings in a stock has little desire to see an analyst put out a "Sell" recommendation on that security and possibly contribute to a sharp decline in its price. Hence the proliferation of euphemistic ratings—such as "Hold," "Retain," and "Market Perform"—which small investors may take at face value, but which professional and institutional investors know are often tantamount to "Sell." As a result, ratings inflation became as widespread and unhealthy in our markets as grade inflation in our schools.

Ownership Interests in the Company. An analyst, other employees, and the firm itself may own significant positions in the companies or market sectors on which the analyst conducts research and makes recommendations. The analyst may own such shares directly, or through employee stock-purchase pools.

These economic realities certainly do not mean that analysts are corrupt or even biased. But because analysts are called upon to make so many judgments that are not black and white, any of the above factors can put pressure on their objectivity—no matter how honest or competent they may be. So you should bear these realities in mind before making an investment decision.

Making Your Investment Decision

The fact that analysts or their firms may have conflicts of interest does not mean that their recommendations are without value. Often research reports will contain quantifiable measures—such as earnings predictions or comparisons to other companies in an industry sector—that you may decide provide useful insight even if you do not take the analyst's rating at face value. In any case, you should take all potential conflicts into consideration in assessing how much weight you should give the recommendation.

The important thing to remember is that you should never rely solely on an analyst recommendation when making an investment decision. There are many other important sources of information and factors you may wish to consider. For example:

Research the company's reports yourself, using the SEC's EDGAR database. If you do not have access to the Internet, call the company for copies. If you can't analyze them on your own, ask your broker or another trusted financial professional for help.

Speak with your broker or financial adviser and ask questions about the company and its prospects. When doing so, ask your broker about the relationship of his own firm, if any, to the company whose stock you are considering.

Learn about the company by consulting independent news reports, commercial databases, and other references.

Find out whether the analyst's firm underwrote one of the company's recent stock offerings—especially its initial public offering (IPO).

Find out more about analyst recommendations by consulting your broker or some of the other sources discussed in this Guide.

In short, whatever a given analyst recommendation may say, always consider whether a particular investment is right for you in light of your own financial circumstances. Remember, you are the boss, it's your money, and your situation and goals that matter.